7th January 2021
A fortnightly look at global financial markets by International Investment Strategist Tom Elliot.
Markets shrug as Senate goes to Democrats, and Trump incites violence on Capitol Hill
More U.S government spending expected to boost U.S and global growth
Tech vs Cyclical stocks – NASDAQ falls, the U.K shines!
Fixed income remains a useful diversifier in a portfolio
The Brexit deal in the words of senior Conservative Party figures
Sterling remains vulnerable, even as the dollar weakens
Surprisingly robust. Given yesterday’s events in the U.S, financial markets are surprisingly calm, which offers reassurance to investors in risk assets. The ‘Blue Wave’ has happened, with Democrats now controlling both houses Congress and the White House, which will mean higher business taxes and a reversal of Trump’s deregulation initiatives. And Trump has made clear his intention to cause as much harm to American’s trust in their democratic institutions as possible. Yet investors have focused on the probability of an extension to the December $900bn stimulus package, which may now be doubled, and the improved prospects for a large infrastructure spending bill. Both of these will support economic recovery, and with that, corporate earnings.
Meanwhile, the roll-out of vaccinations in many developed countries and Russia has begun. Social distancing measures will likely be lifted once the old and vulnerable are immunised. (In the U.K, if one million vaccinations a week is achieved, all old and vulnerable groups could be vaccinated by July, and herd immunity achieved by the end of the year with 46 million of the population vaccinated).
In addition, central banks are in no hurry to raise interest rates and look set to maintain ‘loose’ monetary policy well into the economic recovery. This not only keeps borrowing costs low, helping to stimulate economic growth, it also suppresses interest rates on cash which in turn supports financial assets. Governments are continuing to support economies through a multitude of schemes. In addition to the U.S stimulus mentioned above, the government is offering a further £4.6bn support to businesses, while last month the E.U approved its Euro 750bn post-pandemic growth package.
Both central banks and western governments have learnt from the 2008/9 financial crisis not to take away support from a recovering global economy prematurely.
Tech vs cyclicals
Not all sectors on the U.S stock market are relieved at the Blue Wave. U.S Big Tech and the NASDAQ fell yesterday on fears that Democrats will seek to regulate, and possibly break-up, Silicon Valley’s giants. Furthermore, the prospect of a large injection of cash into the U.S and global economy has boosted interest in cyclical sectors, and service sectors that have been particularly badly affected by the pandemic. The U.K stock market was the best performing within the MSCI World index yesterday, precisely because of its large weighting to ‘old economy’ energy, materials and financial stocks.
As the global recovery develops, the underperformance of tech relative to cyclicals is likely to continue. This might suggest further outperformance for U.K, continental European and Japanese stock markets relative to the U.S.
Fixed income remains a useful diversifier in a portfolio
With the U.S 10-yr Treasury yielding just over 1% again, there is some nervousness amongst investors that inflation is around the corner in the U.S and with it a bear market for fixed income. Certainly inflation is rising, but at 1.3% year-on-year in November it remains well below the Fed’s 2% target. Supply chain bottlenecks, caused by lockdown measures, will result in temporarily higher prices for some goods. But these are likely to be resolved as the U.S economy normalises. Yet unemployment will still be growing (corporate bankruptcies are a lagging feature of an economic downturn). This will weigh on consumer demand, curbing inflation.
A global wave of inflation may happen, and with it a bear market for bonds, once global demand is back to normal and unemployment is mopped up. But there is unlikely to be a problem for 2021. In fact, the U.K, euro zone and Japan are more concerned about the risk of a deflationary spiral setting in and causing further economic pain. In the meantime, the tendency of government bonds to rally during times of stock market stress make them useful diversifiers in a portfolio.
Sterling currently sits at $1.36, a level last seen in April 2018. Near-term downside risks appear limited, now that a U.K/ E.U trade deal has been agreed and the U.K government can focus on the Covid-19 pandemic. (Rarely have we seen a major currency so buffeted by political news, as sterling has by the Brexit story over the last four years). In addition, the U.K stock market is attractive for overseas investors looking to play cyclical sectors, ahead of the global economic recovery.
Instead, the FX community is focusing on the dollar, and betting heavily on further dollar weakness against most currencies. As economic recovery in the U.S sucks in imports, the trade deficit will increase. Meanwhile, the Fed has made it clear that it is in no hurry to raise interest rates even if inflation does reach its 2% target.
The Brexit deal in the words of senior Conservative party figures:
- Wonderful…a new chapter in our national story
— Boris Johnson, current head of the Conservative Party and Prime Minister.
- We have a trade deal that benefits the E.U, but not a deal in services that would benefit the U.K.
— Theresa May, former head of the Conservative Party and Prime Minister, referring to the U.K’s deficit in goods with the E.U.
- What prospects lie ahead of us for young people now: to be out there buccaneering, trading, dominating the world again!
— Ian Duncan Smith, former head of the Conservative Party.
- We are buying a national right to diverge, which we will not use, at a very high economic price
— Philip Hammond, former Chancellor of the Exchequer in Theresa May’s government.
Sterling is not out of the woods, and may yet weaken against the euro and other currencies that lie outside the dollar bloc.
First, the initial wave of Covid-19 hit the U.K economy particularly badly and a full economic recovery may not be achieved until late 2022. Third quarter 2020 GDP was down 8.6% on the same period in 2019 (compared to -2.8% for the U.S, -4.3% for the euro zone, and +4.9% for China). Yet the rebound this year, perhaps of around +4.4% (the OECD estimate in early December), will be in line with the global average. Despite the impressive roll-out of vaccines in the U.K in recent weeks, the economic cost of the second wave of Covid-19, and associated lockdown measures, appear likely to be worse for the U.K than for other developed countries. But this has not yet been factored into 2021 GDP forecasts.
A relatively weak economy means interest rates will remain at very low levels for some time to come, and may yet turn negative, diminishing the attractiveness of sterling.
Second, the Treasury’s forecast of a 5% hit to GDP growth over the next 15 years in the event of a hard Brexit has yet to be played out. But we are already seeing how this might occur. There is plenty of anecdotal evidence that new paperwork and physical customs checks is slowing down and discouraging U.K/E.U trade, which will result in reduced economic activity with a disproportionate impact on the U.K. This may be a temporary phenomenon, as traders get used to the new regime, but one surprising result of Brexit is that the paperwork required to send goods from England to Northern Ireland and other parts of the E.U’s single market is now similar to that required to export to the Philippines.
We have yet to see if foreign direct investment into the U.K will recover after the pandemic. But the U.K may no longer be an attractive gateway into the E.U for manufacturers, if the U.K starts to deviate from the E.U ‘level playing field’ rules and standards.
Meanwhile, the much larger services sector has no Brexit deal. We have already seen, on 4th January, Euro 6bn worth of E.U companies’ shares removed from the U.K hubs of pan-European exchanges and relocated to Amsterdam, Berlin, Paris and Dublin.
Third, Brexit is causing repercussions for the integrity of the United Kingdom, which may weigh on sterling since the division of financial liabilities and assets is unclear. Northern Ireland remains in the E.U’s single market and customs union, which is likely to encourage still greater trade links and weaken trade with the rest of the U.K. This may hasten the process of Irish unification.
In Scotland, which voted by some margin to remain in the E.U, the SNP will fight this year’s Scottish Parliament election with an anti-Brexit, pro-E.U message to voters and demand a second referendum. Conservative Party claims that a land border with the E.U and the north of England will be impossible to manage will be undermined by their apparent willingness to implement a border between Northern Ireland and the mainland (which, even though is called a ‘sea border’, in fact relies on land checks on either side).
As always, investors should be as diversified as possible in order to maximise returns relative to risk (ie, volatility). This means geographical, sector, and asset class diversification.